Banking Risks Reflected in Moody’s Downgrades

Credit ratings agency Moody’s Investors Service recently downgraded the ratings of 15 major banks in a move that was expected to harm the financial results of these institutions.

“The risks of this industry became apparent in the financial crisis,” said Robert Young, a managing director at Moody’s, about the downgrades. “These new ratings capture those risks.”

After the downgrades, the banks stand barely above the minimum for an investment-grade rating, a sign of the difficult business conditions they face. With lower ratings, creditors could charge the banks more on their loans. Big clients may also move their business to less-risky companies, further crimping earnings.

Downgrades Despite Interventions

The downgrades come despite the banks operating in an environment where their cost of capital is nil and governments have been intervening to help with borrower bankruptcies and distressed loans.

The bank problems result from unwise and even illegal practices and likely will continue for some time, said Trish Rogers, a partner at Denver law firm Moye White.

“The recent downgrades are due in part to Barclays’ scandal [falsely reporting low costs to borrow money from other banks],” Rogers said. Even though the scandal didn’t come to light until after the downgrades, Moody’s likely had some inkling of the situation when making its decision, according to Rogers.

“Other banks were likely participating in the distrust,” Rogers said. “Now no one trusts LIBOR, no one trusts interest rates.” The London Interbank Offered Rate is used to set interest rates on numerous kinds of loans around the world. Interest rates reported by major banks when they borrow money set the LIBOR rate.

Dodd-Frank Impacts

Another key issue is Dodd-Frank financial regulations and questions regarding banks’ continued participation in derivatives and other nontraditional banking markets.

Dodd-Frank requires that banks reserve more capital to protect against default, which ties up money that otherwise could be invested. Banks are still behind the curve in meeting Dodd-Frank requirements, so they will have to play catch-up by reserving more capital than they currently have, Rogers said.

Banks also need to serve shareholders, which in the current economic environment of weak demand for traditional banking products and services, has big banks trying to provide more nontraditional financial services. Rogers suggested banks spin off traditional banking businesses from nontraditional financial services businesses.

Banks are still suffering from some of the decisions they made in the traditional part of their business, says Tom Stanton, a staff member of the Financial Crisis Inquiry Commission in 2010 and 2011. Stanton is a fellow of the Center for Advanced Governmental Studies at the Johns Hopkins University and author of Why Some Firms Thrive While Others Fail: Governance and Management Lessons from the Crisis.

Past Mistakes, Current Problems

“Part of the problem is that the banks are coming off a huge relaxing of credit standards to make loans,” Stanton said. “The economic downturn was unbelievably painful. Banks lost trillions of dollars for people, and then people started reducing debt and borrowing less. We are still hovering at the edge of a recession. Banks don’t find opportunity to lend money in that environment.”

Before the crisis, banks were making seriously flawed financial decisions, and they’re still doing so, Stanton said. Part of the reason was a lack of vigilance as loans went bad and economic conditions changed, similar to earlier banking crises. As a result, there is a serious lack of confidence in the banking industry among investors, which was part of the reason for the Moody’s downgrade.

Ron Ashkenes, senior partner for Schaffer Consulting in Stamford, Connecticut, says the Dodd-Frank rules have created additional uncertainty. Although many of the rules make sense in and of themselves, taken together they add a level of complexity that banks and investors find hard to comprehend.

Compensation Problems

Stanton and Ashkenes both say bank compensation structures continue to hurt the industry. Banks tend to reward short-term performance without regard to long-term considerations. The originator of a loan is rewarded when the credit is awarded, even though a loan may go bad a short while later.